Ramblings of a Silicon Valley Tech Exec on Technology Commercialization and Startups

Sunday, March 20, 2011

How to Set Prices: Pricing Strategy

1st in a series on How to Set Pricing

I recently received the student feedback from BUS213: Monetizing Marketing Models, the course I taught for Stanford Continuing Studies during the Winter 2011 quarter. Overall, the course was well received. But the number one area where students would have liked to go deeper was in how to set pricing.

So for those of my former students who may be reading this blog, I've decided to do a series of in-depth posts that I hope will be helpful in this area. The first few posts will deal with an overview and frameworks. The last with tactics and practical tips.

Pricing Overview
As anyone who has studied Marketing 101 knows, Price is one of the classic "4Ps" of the marketing mix (the others being Product, Promotion, and Place). In setting prices, three major elements need to be considered:

Pricing Strategy

Business Revenue Model

Pricing Mechanisms

Setting prices can be a fairly technical marketing specialty, particularly in well established consumer product categories like packaged goods, the travel industries, and commodities. For the purposes of this discussion, I will focus on the less scientific and more "seat-of-the-pants" situations encountered by entrepreneurs in less well defined B2B and B2C markets.

Pricing Objectives
There are three main objectives to be considered in setting prices:

Cost/profit- Pricing must be set sufficient to cover costs and generate a sufficient profit to support and grow the business. What complicates this is the nature of the revenue model and time frame over which profits are generated.

Market positioning - Prices are a key signal to prospective buyers of a product or businesses market position. In known product categories, they can establish buyer expectations for the product. For example, if a car sells for $90,000 and another sells for $15,000 a buyer will have a certain image of what one car is versus the other. Where a product category is new to the buyer, pricing can establish a reference point for comparative expectation versus competitive substitutes. The main thing to remember is that pricing should be set consistent with a company's brand and market positioning.

Market share - Pricing can affect the rate at which a product penetrates a market. In general, cheaper pricing creates less buyer resistance during the sale process and promotes faster product adoption and share growth. But not always. When Mercedes first released the C-Class with pricing in the low $30,000s, because the price was so counter to the company's luxury brand image, it actually impeded consumer acceptance. The other factor here is what competitors are charging. Depending on the nature of competition within an industry, this may limit what prices can be set. For example, in commodity businesses, it is almost impossible to establish premium pricing due the existence of interchangeable competitive substitutes. And price decreases are matched almost instantly by competitors. But in luxury goods, where the value of the products are more intangible, a wide variation in pricing can exist.

Ideally, prices should be set to maximize business profitability over time. Profit over time is a function of unit price, unit volume (i.e. share), and time.

Pricing Strategies
A company's price strategy is the way in which it decides how to blend the tradeoffs between the various objectives above. It must be set as part of a company's overall competitive strategy. For example, if the company is in a new technology sector with low barriers to entry (i.e. social media) where much of its value is based on its network, it may need to pursue a first to market, fast growth approach. In this case, it may want to pursue a loss leader price strategy in order to facilitate this.

While the variations are endless, the most common generic price strategies are:

Predatory - This is where a company prices its product at very low margin, or even at cost* in order to gain entry into a new market. Over time, as the company establishes a more dominant share position, it increases prices to be more in line with its target brand position. This often used where a new entrant is seeking entry into an existing market with established competition. Predatory pricing is not without its pitfalls including:

Sending the wrong positioning signal to the market

Difficulty in raising prices due to customer backlash

Sacrificing negotiating room

Leaving money on the table

Difficulty in covering costs

Skimming - At the opposite end of the spectrum, this is where a company prices at a premium to capture the high end segments first. Then as it saturates a buyer segment, it drops prices to appeal to new buyer segments. This strategy requires that some meaningful differentiation exists to support a premium price segment. Skimming also has its pitfalls including:

Increases sales resistance, lowers demand, and slows sales adoption

Creates an umbrella for competitive entry

Creates customer "ill will"

Gives customers an incentive to search for alternatives

Bundling - This is an intermediate strategy where a company groups together different products and features in such a way that it can offer variations at different prices. This gives the company great flexibility to offer a combination of features that appeals most to different buyer segments while maximizing the profitability of the various offerings. An example of this is the automobile industry where the variety of packages can be overwhelming. By bundling together desirable but costly features (e.g. automotive transmission) with less desirable but more profitable features (e.g. "all weather" package), the overall profitability of the car can be optimized.

Multi-tier - This is another intermediate strategy where the company offers distinct product categories at different price segments to appeal to different buyers. Again, an example from the auto industry is Toyota used to offer a mainstream (Toyota) and luxury (Lexus) model under different brands for substantially the same car (Camry vs. ES300). Another example would be the freemium model practiced by the SaaS industry where it is common to offer both a basic free version and a premium paid version.

Next post: Revenue Models and Price Mechanisms

* Note: Setting prices below direct costs is illegal in many countries. While often difficult to prove given the creativity in cost accounting allocations, the practice of "dumping" or predatory share pricing has been the subject of several WTC actions in the past. One such high-profile case involved the sale of Korean DRAM memory chips to the U.S. in the 1990s.